The Pros and Cons of Financial Innovation

Douglas J. Elliott
Douglas J. Elliott Former Brookings Expert, Partner - Oliver Wyman

February 25, 2010

Innovation is a two-edged sword. The internet has been a great boon to society overall, but also promotes pornography (apparently the largest web-based business by a considerable distance), fraud, and a great deal of time-wasting activity. The automobile and other motor vehicles brought mobility, freedom, and massive economic efficiencies. They also brought over 40,000 deaths each year in the U.S. alone, most of them preventable, along with major pollution problems and suburban sprawl.

Innovation in financial services is no exception to the rule that every silver lining has a cloud. I believe that it has done considerably more good than harm, but it has undeniably caused damage. The intertwining of benefit and harm means that any assessment of financial innovation will necessarily be subjective. First, there is no clear, objective way of balancing the good and the bad. Think again of automobiles. One could conceivably believe that the deaths and the pollution outweighed the economic and societal gains, although this would clearly be a minority view. Second, it is exceedingly hard to measure the effects of financial innovation. For example, most analysts would agree that financial innovation helped cause the recent terrible financial crisis, but its culpability ranges from secondary to severe, depending on one’s theory of why the crisis happened and how it evolved.

A further complication is that “financial innovation” is not monolithic. Careful observers accept that some financial innovations are good, like the invention of the ATM that was praised even by Paul Volcker. Other innovations, like the late and unlamented Structured Investment Vehicles (SIV’s), are bad. The real trick is listing and evaluating the major innovations and determining the balance of the good and the bad. On that score, I highly recommend a recent article by my Brookings colleague, Robert Litan, who does just that.

Recent discussions of financial innovation have been heavily negative on balance, so let me list some of the financial innovations since the 1960’s that Litan viewed as significantly more positive than negative:

• Automated Teller Machines (ATMs)
• The massive expansion of credit card usage
• Debit cards
• Money market funds
• Indexed mutual funds
• Exchange Traded Funds (ETFs) as a kind of extension of indexed funds
• Treasury Inflation Protected Securities (TIPS)
• Credit scoring to assist in lending decisions
• Basic forms of securitization
• Venture capital funds
• Interest rate and currency swaps

The overall negative characterizations of financial innovation have been strongly driven by the disasters wrought by the recent financial crisis. Clearly, some of the recent financial innovations such as Collateralized Debt Obligations (CDOs), SIVs, and Credit Default Swaps (CDSs) were abused, taken several steps too far, or even, in the case of SIVs, simply a bad idea in the first place.  In some theories of the crisis, these innovations play a central role, with the implication that without them we would have suffered far more minor pain. If one accepts these views, then there are at least certain types of innovation that do so much harm that we as a society should be exceedingly cautious about financial innovation in general.

There is not space here for anything like a full discussion of the causes of the financial crisis, but let me just note that there are many respectable theories of the crisis in which these innovations play a much more modest facilitating role. For example, many conservatives, such as Peter Wallison, place much of the blame for the crisis on government actions. Home ownership was pushed so hard as a societal goal that it inflated a massive housing bubble and allowed, perhaps even forced, Fannie Mae and Freddie Mac and the larger banks to take truly excessive mortgage risks. This combined with excessively easy money to create an overall bubble of mammoth proportions whose bursting was bound to do great damage. In this critique, financial innovation helped mask or exacerbate otherwise bad actions, but was clearly not a major cause in itself.

My own view is that there were many, many causes of the financial crisis and that individuals and institutions of almost all stripes made major mistakes, including Wall Street, the rating agencies, the Administration, Congress, regulators, individuals as homebuyers, and individuals as investors. A principal underlying reason so many people contributed in so many ways to the crisis was an excessive relaxation about and underestimation of risk that stemmed from 25 years of very favorable financial markets interrupted by only brief storms. When things go so well for so long, mistakes of over-confidence will abound. (See a previous paper for more on my views of the crisis.) Viewed in that light, bad financial innovations or misuse of good ones were important contributors, but we should be careful not to overestimate their effects.

If all this is so complicated, why should we even bother evaluating “financial innovation” as a concept? The reason is that we are facing major choices about how to regulate financial institutions and markets, choices which will have a substantial effect on the volume and form of future financial innovations. If you believe, as I do, that financial innovation has been more positive than negative, then it makes sense not to regulate them away by imposing excessively harsh standards or outright bans on new products. The current overall approach remains the right one, although it needs to be executed better. Let innovation occur and react appropriately to any flaws that become apparent. However, I must emphasize the need for regulators to pay more careful attention and to react quicker and more sharply to problems. The laxity of regulators allowed bad financial innovation to create much unnecessary harm, even given the two-edged nature of innovation.